Bank Earnings Jump on Accounting Gimmicks, Again

Accounting rules allow banks to show gains when their bond market holdings rise. This is what they did several years ago to justify increasing their leverage, allowing them to buy even more bonds and show even more gains. In the end, that accounting rule contributed to the financial crisis in 2008 as the bubble burst.

To make sure the American consumer could never be hurt like that again, Representative Barney Frank and Senator Chris Dodd led efforts to craft a new law that would make big banks more responsible and less creative in their earnings reports.

In the most recent quarter, some big banks demonstrated that accounting gimmicks have survived the crisis.

Traders in the bond markets have been selling bank debt, worried about their exposure to Europe and other brewing financial problems. Selling the debt led to lower market prices for the bank’s bonds. An accounting rule allows banks to recognize the total value of the lower prices as income.

This would be similar to a consumer claiming $250,000 in income because their half-million dollar home fell in value by 50 percent and their mortgage is now hopelessly underwater. As an accounting adjustment, the bank owes no income taxes, but unwary investors see much higher earnings per share.

JPMorgan boosted earnings by 80 percent with this trick, as bond market fears allowed the company to add $1.9 billion in income. Citigroup also added $1.9 billion in income, doubling reported earnings, because bond market investors sold their debt over fears about Citi’s long-term solvency.

Other accounting gimmicks are available to publicly traded companies and investors need to be cautious when reading earnings report. Cash flow may present a better measure of the company’s health, and by that measure, big banks are showing much slower growth.

Accounting rules allow banks to show gains when their bond market holdings rise. This is what they did several years ago to justify increasing their leverage, allowing them to buy even more bonds and show even more gains. In the end, that accounting rule contributed to the...